11/15/2013

I was (re)introduced to monetary policy operations when I came
across the work
of Scott Fullwiler a couple of years ago. Reading his papers, it soon became apparent to me that there were some serious discrepancies
between what I was taught about monetary policy in college and how Fullwiler explains
it is actually implemented by real-world central banks. This was odd and
distressing to me. Could it really be true that mainstream monetary policy theory
was this divorced from reality? At this point in my research, the answer seems to be “yes”
and “no.” Ulrich Bindseil’sbook, which I discussed in aprevious post, supports this notion. Bindseil is the Deputy Director General of Market Operations at the European Central Bank.

I think it is “yes” in the sense that there are rigorous and well-developed
arguments coming not just from Fullwiler but from a fairly extensive body of
work that supports the notion that certain lineages of academic monetary policy
theory have departed from accurate descriptions of what is feasible in reality.
This body of work is not just in the domain of historic central banking experts,
such as Walter Bagehot, or fringe economic schools, such as Post-Keynesian
economics. Over the past two decades, it has become embraced by central bank
authorities around the world and by certain strains of mainstream macroeconomic
theory, with econ demi-god Michael Woodford notably one of the leaders of the
latter front.

However, I also think it is “no” in two senses. The first sense is that, well, as I noted above, some of
the most recent mainstream theory is now relatively on board – i.e., Woodford and company.
The problem seems to be that many other scholars have not caught up, and most textbooks
have not been updated. The second sense is that a critical distinction needs to
be made between monetary policy implementation
and monetary policy strategy.
While many academics have for a long time conflated the two to the detriment of
the coherency of their ideas, they have arguably proposed legitimate theories
of the latter (which I am not endorsing or critiquing here) that indeed inform
central banking practice to this day.

In the era of academic, blogospheric, and media debate
regarding novel and complex approaches to central banking, such as “NGDP
targeting,” these two concepts of strategy vs. implementation continue to be conflated, to the detriment of
the dialogue that is taking place. People focused on 'strategy' often talk past people focused on 'implementation,' and the discussion sort of goes nowhere As
such, I aim to define and outline these two concepts in this post, with the
hope that it can provide a useful template for thinking about monetary policy.

I borrow the specific framing and terminology below from
Bindseil. I presume, given that he is an operations authority within the ECB,
that these are common ways central bankers view this topic. However, alternate
terminology likely exists, as well as slight modifications to the framework used.
Scott Fullwiler has noted that these general concepts are common in the policy
sciences, as well as in the business and management literature. Depending on the
context, I am sure different terminology is used. For example, I’ve
seen Fullwiler specifically refer to a three-pronged framework, which consists of 'tactics,' 'strategy,' and 'policy.' 'Tactics' corresponds to what is described as 'implementation' below, whereas 'strategy' and 'policy' are subdivisions of what is described as 'strategy' below.

Defining Monetary
Policy Implementation and Strategy

At a high level, I would describe the relationship between
monetary policy implementation and strategy as the following: monetary policy
implementation refers to the means by which central banks intervene in markets
when attempting to achieve the overarching goals set out by monetary policy
strategy. The following bullets define and describe these concepts in more
detail.

Monetary policy
strategy consists of two main elements:

A macroeconomic model of the transmission mechanisms of
monetary policy

One element of monetary policy strategy is the central bank’s macroeconomic model of the
transmission mechanisms through which it believes monetary policy is supposed to impact the
economy. In other words, this model captures how the central bank’s final
target is linked to its operational targets, indicator variables, and
intermediate targets.

The final target
of monetary policy is the economic variable(s) that the central bank ultimately
aims to impact. Transmission of the central bank’s strategy starts with its operational
target, which may then impact its intermediate targets, which then impacts the
final target. The final target is often referred to in a central bank’s
statute, such as pursuing high employment and stable prices, however defined.

Operational targets
will be defined below in the context of monetary policy implementation.

Intermediate targets
are variables a CB believes they can control with a reasonable time lag and
with a reasonable degree of precision and which is in a stable or predictable
relationship with the final target of monetary policy. Examples may include
medium term interest rates, long term interest rates, the exchange rate, and
monetary aggregates. Bindseil reports that the concept of ‘intermediate
targets’ have fallen out of favor and are often referred to as indicator
variables.

Indicator variables
provide data that inform how the central bank may need to adjust its
operational target variable to ultimately impact the final target. Bindseil
offers examples of ‘exogenous’ variables such supply side shocks and technological
innovations. As noted above, intermediate targets could be included in this
category as well.

Rules for operational adjustment

The second element of monetary policy strategy consists of
the manner in which the central bank adjusts its operational targets in
response to new information and communicates this to the public in order to
achieve its final target.

Monetary policy
implementation consists of three main elements:

The operational target of monetary policy

The operational target
is something that the central bank wants to and can control on a daily basis
through use of its monetary policy instruments as a means of achieving the
goals laid out by the chosen monetary policy strategy.

Today, there is broad consensus among central banks that the
short-term inter-bank interest rate is the appropriate operational target. However, in the past and still today, many academics argue that quantitative variables, such as the monetary base, are
preferable. That said, arguably the most popular mainstream macroeconomic theory, New
Keynesianism, takes the interest rate view.

The framework for controlling the operational target

The CB controls the operational target using monetary policy instruments

The main monetary policy instruments used today are standing
facilities (i.e., interest on reserves and lending facilities), open market
operations (OMOs), and reserve requirements

Daily use of instruments to achieve the operational target

This may include conducting OMOs, changing
standing facility rate, and changing reserve requirements

One thing you may be wondering is where the roles of communication
policy and forward guidance fit into this. I’m only half way through Bindseil’s
book, but it seems these issues aren’t addressed very much (as I noted in my previous post, an updated version that addresses the post-financial crisis world of central banking would be nice). This may be a deficiency, but I think there are a
couple reasons for this. First, things like communication and forward guidance
may fit more within the realm of monetary policy strategy, which is suggested in the summary above, and Bindseil's book focuses on implementation. Secondly, as a central banker and someone intimate with the modern mathematical
models describing how monetary policy implementation works, Bindseil places a
great deal of importance on taking action to not just back up the credibility
of central banks but more so to actually achieve their operational goals. In other
words, at least with respect to targeting interest rates, Bindseil shows how
the best models out there demonstrate that simply announcing your intentions is
not sufficient without use or adjustment of one of the policy instruments (including the standing facilities). Fear not
heterodox readers, Bindseil still appears consistent with the Post-Keynesian
descriptions of interest rate targeting that I've read, as I’ll describe in a future post. And
fear not NGDP targeters (at least in some respects), as we’re talking about
implementation and interest rate policy here, not the broader strategy.

The Nexus Between
Monetary Policy Strategy and Operations

Bindseil conceives of there being a
hand-off from monetary policy strategy to monetary policy implementation. In other
words, using the central bank's model of the economy, the strategists determine what the operational
target should be at any given moment, and then communicate this to the
implementation experts, who then work to hit the operational target in the real world. Indeed, from lecture notes online, Bindseil observes there is often a division of labor and expertise between
these two areas within central banks:

“Monetary policy can be said to have a Sollbruchstelle (a
predetermined breaking point), which is where
the monetary macroeconomists hand over the short term interest level,
identified as optimal to achieve the ultimate target, to the implementation
experts. While the first function belongs to the area of “white-collar” central
banking and is usually performed by the economics department (with
involvement of the research department),
the second function belongs to the “blue collar” areas, for instance, in the European Central Bank it is carried out by a
department called “Market Operations”. In principle, monetary macro-economists in central banks do
not need to understand monetary policy
implementation and, symmetrically, implementation experts do not need to
understand much about monetary policy
strategy and the transmission mechanism. Actually, the resulting efficiency
gains that specialization allows are
normally realized in central banks, i.e. there are no attempts to make implementation experts at the same time
macro-monetary economics specialists, and vice-versa. This segregation between the two functions may
also be called a “dichotomy” between monetary
macroeconomics and monetary policy implementation. Others have referred
to it as the “separation principle” of
monetary policy implementation. One may also speak about a “hierarchy”
organizing monetary policy, with the
choice of the ultimate target at the top, followed by the analysis of the transmission mechanism and the associated
identification of the optimal level of the operational target of monetary policy,
and with monetary policy implementation finally achieving this target
through monetary policy operations.”

Interestingly, judging by what Bindseil writes in his book, he would probably go further to suggest that prior attempts of “white collar” economists to delve into the realm of “blue collar” central banking is what led to 20th century confusion regarding how monetary policy actually works. As such, I'm a bit surprised that Bindseil would use such seemingly disparaging terms, although perhaps he is reporting the reality.* EDIT: In my opinion, this is not to say the two groups shouldn't understand what each other is doing. To the contrary, it seems the lesson from the '20th century confusion' is not that the two groups should stay separate, but that they should be intimately familiar with each other's domain.

Without getting too much into the history here (for another post), Bindseil notes that the term “instrument” was understood in an ambiguous way in the influential article of Poole (1970), namely to designate both operational and intermediate targets (specifically short-term interest rates and monetary aggregates). This, he believes, has contributed to a persistent misunderstanding among many academics that the central bank can reliably use the monetary base as an operational target. Instead, Bindseil strongly believes it is fundamentally interest rates that CBs can control as operational targets, whereas targets such as the monetary base are at best intermediate or final targets. This is, by the way, consistent with what Post-Keynesians argue.

Finally, one argument Bindseil sets out to defend in the book is the following:

“Monetary policy strategy is not of key relevance to choosing an appropriate approach to monetary policy implementation: monetary policy is necessarily implemented through control of short-term interest rates, irrespective of strategy.”

I won't attempt to explain why Bindseil believes this yet. Again, this will take at least another post, and I need to first broach the topic of interest rates vs. quantities. I'll leave this as food for thought for now, without insinuating any degree to which this may be wrong or right.

Application to NGDP Targeting

Recently, there was a strong and partially successful push for the Fed to alter its prior strategy of inflation targeting (guided by concepts such as the Taylor rule) to an approach called “NGDP targeting.”

This advocacy campaign has its roots both in the blogosphere and more formal domains of academia (on the relevancy and benefits of the two, see, for instance, Krugman here). Bentley professor Scott Sumner and his fellow “market monetarists” are largely responsible for popularizing the idea on the blogosphere and in mainstream economics news sources. This publicity has certainly reached a wide audience, including economists. However, NGDP targeting and related variants have also been discussed within academia for at least a decade. The crescendo of consensus on NGDP targeting reached a considerable volume when FOMC voting member Charles Evans and former CEA chairwomen Christina Romer bothendorsedthe idea in 2011. The push for NGDP targeting reached a high pointwhen in September 2012, Michael Woodford presented a paper advocating NGDP targeting at the annual Jackson Hole conference hosted by the Federal Reserve Bank of Kansas City. Finally, in December 2012, the Fed made a historic shift in its approach to monetary policy by adopting the ‘Evans Rule,’ which moved Fed policy much closer to the concept of NGDP targeting.

NGDP targeting is definitely still a somewhat controversial idea, even though it has a broad base of support. It's controversial among mainstream as well as heterodox economists. Probably the most common critique is: "Where is the transmission mechanism?"

Again, I reserve my right not to get into this debate here. However, what I would like to do here is implore supporters of NGDP targeting to explain how this monetary policy approach maps to Bindseil's policy framework above. After all, if this idea is to be used by central banks, then it will probably need to be mapped in such a manner one way or another. So, within the context of policy implementation, what are the operational targets? What instruments will be used to achieve these operational targets, and how will this be done? Within the context of strategy, what are the indicator and final variables? What rules for operational adjustment and communication policies will be used to achieve the goal NGDP targeting?

Many of the answers to the strategy questions above have been repeatedly provided by NGDP supporters, albeit not within the context of the framework laid out above. However, I find the answers on the transmission mechanism and implementation sides lacking. Much is said about forward guidance, but there needs to be more, as the economy may not automatically do what the central bank claims it wants to happen (said in an admittedly tongue in cheek fashion).

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*As a side note, I find it interesting that the connotations of these terms parallel a common grievance of heterodox economists and bloggers, which is that mainstream economists often express (an unjustified) scorn to an accounting and flow of funds oriented approach to understanding the economy, or what Perry Mehrling might call “the money view” approach to economics.

Thanks! You can try following along at first. I do intend to summarize the book to the best of my ability. An alternative is that you can try a local library. Also, I haven't dug deeply through the link to the online lectures notes, but it does seem to summarize much of the book.

The blue collar-white collar distinction is interesting. The first concerns itself with how to achieve something, the second with what to achieve. We can add a third group to the mix that tries to determine if the whole effort is legal and/or politically feasible. Even if the white collar strategy can be implemented by blue collar techniques, does it lie within the set of rules that governs the central bank? NGDP targeting needs not only a legitimate blue-collar transmission mechanism but also a legally viable one.

Agreed. JKH and Fullwiler have also thrown another distinction of 'policy' into the mix. They may be using it differently, but I think I could see use for an additional dimension like this. Will continue to think this over.

"Interestingly, judging by what Bindseil writes in his book, he would probably go further to suggest that prior attempts of “white collar” economists to delve into the realm of “blue collar” central banking is what led to 20th century confusion regarding how monetary policy actually works."

I think that the current monetary policy system is unnecessarily complex needing a division between white collar and blue collar central banking. But if the this counterproductive complexity was done away with strategy and operations should be efficiently managed by the same people.